Transition to Retirement Taxation
When you are making the transition to retirement, you enter a period in your life when you will live off of your savings. This presents some challenges from a tax perspective. There are a few ways you can deal with this transition so that you maximize your retirement income while reducing the amount of tax you pay.
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Gather Retirement Accounts
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First you must address where all of your retirement income will be coming from. If you have saved most of your own retirement savings in a 401(k) plan, for example, then you will use this as the primary account. However, if you receive a pension, have money in a 401(k) and own several IRAs and a cash value life insurance policy, then you must gather all of this information. You should take note of what portion of your retirement savings represents traditional retirement accounts that will be taxed when you withdraw money from them and what portion of your retirement accounts represents tax-free accounts, such as Roth IRAs or any cash value in a cash value life insurance policy.
Analyze Options
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Determine how you want to receive your retirement income. If you want to avoid future taxation of your retirement benefits, then you may want to consider converting your retirement accounts to a Roth IRA. If you think you'd be better off keeping your money in your traditional retirement accounts, then do not convert your accounts.
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Analyze Benefits
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The benefit of converting to a Roth account is the ability to withdraw money from the account, in any dollar amount, without paying income tax. Another benefit to converting to a Roth account is that you don't have to worry about future tax rates since you don't pay income tax on withdrawals. In this way, the Roth account encourages you to do as well as you can in your investments since you won't be taxed on a larger dollar amount in the future. Similar benefits are available with cash value life insurance. Withdrawals up to your basis (the total amount in premiums you've paid) are tax free, and policy loans are not taxed as income.
Analyze Disadvantages
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This tax-free benefit of a Roth is only available after age 59 1/2. Prior to this age, a 10 percent penalty and income tax is due on all withdrawals. Additionally, you must pay ordinary income tax on all money you convert to a Roth account. When taking withdrawals in excess of your basis, you are taxed at ordinary income tax rates. Additionally, if the policy terminates and you have any outstanding loans, these loans are treated as income and all money you receive in excess of your basis is taxed at ordinary income tax rates.
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